"Gold was such an anchor or rule, prior to World War I, but it was first compromised and eventually abandoned because it restrained the type of discretionary monetary and fiscal policies that modern democracies appear to value. " Alan Greenspan, 05 September 1997.
He made this comment while he was in the process of describing the shifting modus operandi of the Federal Open Market Committee (FOMC) in 1997, which was increasingly to become discretionary in its policy deliberations - meaning that they tossed out the rules and that the balance of risks in policy making immediately shifted toward inflation. In effect, what he was telling us was that "Economic Freedom"1 was simply not possible within modern democracy (otherwise known as the new economy if he were speaking today). It was that epiphany, which may have been partly responsible for the ensuing crisis of confidence in gold prices, and has bestowed upon our central bank the task of eternal economic vigilance.
Despite rising inflation and collapsing currencies, in Europe and the UK, equities overseas seem to be in a holding pattern awaiting a signal from their salient leaders in New York. The exceptions are the German DAX and the Nikkei, which have undeniably already turned down. What I like about the Yen is that it has been able to hold a trading range over the past year in the face of a 25% stock market hit and general dollar strength globally. Considering that that was where much of the foreign capital went during the Yen rally last year, it could be taken as a sign of market confidence that this capital hasn't reversed course yet.
We noted our expected move to 3500 on the Nasdaq composite last week, but we didn't suspect such a quick retest of the lows first (at least not until around Tuesday) before it got there. This is important because the sell off and subsequent reversal put in a nice looking reversal pattern on the charts, at least for the short term. After a 1000 point (25%) loss evenly spread throughout the last six long weeks, the dynamics (momentum) of that pattern (quick double bottom) could conceivably guide prices back to their 200 day moving average, up at the 4000 level. Thus if I were managing a short position, I would raise my risk (range) from last week's maximum expectation of 3500-3700 to 3700-4000.
However, if you do contemplate a long position, remember that you will be fighting the primary market trend. Furthermore, the Dow industrials and the NYSE Composite appear to want to lag this bullish comeback. The momentum wasn't broad enough by Friday to make any bullish conclusions on those averages, even if they hadn't moved as far below their 200-day moving average as their Nasdaq/SP500 brethren, in the first place.
They still think it is a bull
Bulls continue to develop their fantasy that what this market needs, in order for it to go up, is for someone else to push it down hard. If they think that they got that result last week, they should have come in Monday morning with their pistols blazing and their sights aimed at unwinding the rest of their hedge accounts. Consider how quickly bearish sentiment swung around:
Yet, as I write this, on Monday morning (9:13:10 AM PST), it appears that bullish momentum has run plum out, having been spent on the drug and biotech stocks nearly right after the opening bell. One of the "paper" weights pulling down the Dow this morning is the share price of General Electric, who had just announced its purchase of Honeywell International overnight. Notwithstanding the dilution of a $48 Billion dollar deal, arbitragers immediately adjusted the market to where the real liquidity is. Unfortunately, the move did some significant damage to the technical condition of this market.
Among the more bullishly (short term) developing charts going into this week are probably the following two:
Hence, this is likely where the bulls will focus their effort. Among the more bearish developing charts going into this week, in my opinion, are the following two:
The dollar index3 continues to put in a strong performance on an inverting yield curve, which probably reflects some movement of speculative capital up the curve in anticipation of a 1998 style bounce. Some liquidity has undoubtedly entered the US treasury market from abroad on Middle East tensions, most of it coming from Canada, Europe, and Australia, judging by the performance of their respective currencies against the dollar over the last few weeks. And some has come at the expense of the collapsing corporate bond sector.
Still, the chart of the long bond leaves much to be desired. Perhaps there is some doubt about the credibility of a budget surplus, which everyone knows is not really a surplus but which nobody wants to call a deficit.
What the Treasury market does have going for it is the rising dollar exchange rate, but that is a double-edged sword. For what it has going against it is an irreversible trade deficit, politicians who are already promising a bigger piece of an uncertain future pie, generally rising inflation rates (even in dollar terms) and the prospect for even higher inflation, high consumer time preference rates, which are negating the so-called capital deepening effect of low interest rates that we left behind years ago, and if we are right about the consumer, potentially a deep recession that will aggravate perceptions of the balanced budget.
The global investment climate has got to account for (or discount) the unfolding crisis in the Middle East. The United States is going to have to make a decision soon and it might be appropriate for them to remind everyone of what is their official relationship with Israel today. I am personally not entirely clear on it. Nor am I by any means confident about the depth of my understanding of the nature of the eternally long dispute between Israel and the Arabs, except to the extent that both, their deeply divided religious views and their political differences center on Jerusalem. Yet a proper analysis is important to our investment hypothesis.
Analysis by Stratfor thoughtfully reveals that the failure at Camp David was the catalyst for the sequence of events that followed. According to their analysis, "Rather than allowing quiet, informal arrangements on the ground to govern the evolution on the relationship, Clinton tried to engineer a comprehensive, formal, top-down solution" to the peace process, when neither Barak (Israel Prime Minister) nor Arafat (Pal.. leader) were anywhere close to confident in each others leadership. In other words, President Clinton was a little overly ambitious.
This is a good analysis in my view, as it was mostly made before the situation escalated. As a result, "both sides faced the abyss of peace and, in effect, chose war as the lesser evil and safer course." It is little wonder then that the Peace Summit in Egypt ended in a timeout on PEACE. Over the weekend, a consensus has been building that the two sides are never going to get along.
The United States, it appears, is going to face intensifying international pressure to have to take a side, or pull support for both sides altogether. And unless they are going to side with the Arabs, the latter might be the safest route in the end. In all probability, the violence will only escalate, stoking inflationary fires.
It can't happen to us
While we are on the topic of inflation again, I stumbled upon an article that caught my eye. Perhaps because embedded deep in my mind has been the search for a way to answer the following question, which is fundamental to my inflation analysis / hypothesis:
How can shortages of "hard" currency result in inflation rather than deflation?
I will try to answer that question today. The Associated Press wrote the article, and it was titled... "Inflation Spurs Rioting in Zimbabwe."
I was mesmerized to hear Eric Benhamou, the 3-Comm CEO, simultaneously discuss how much money his company just made on Palm (those little handheld computers), while reading about how angry mobs were battling local authorities over the rising prices for food, in Zimbabwe. Imagine that for a moment. I guess they have more important things to worry about over there.
The rapid rise in prices for food, transportation, and other basic necessities is not happening because the Zimbabwe economy is overheating, for it is happening while their unemployment rate soars (to over 50%). Stagflation? No… currency abuse. The problem there, as reported by the Associated press, is a shortage of hard currency, not a shortage of food, gasoline, or labor. Allow me to explain.
The central bank has responded to the inflationary crisis by linking the bank rate to inflation, which is roughly around 60% annually, and by growing money supply at an annual rate of 37% with an explicit policy, which favors a weak foreign exchange rate (presumably to gain advantage in trade). In the meantime, inflation and high interest rates have choked off the economy and private forecasts call for up to a 10% decline in GDP next year. Yet there is inflation. Do you see what is causing it yet? No, it is not overheated demand. It is a combination of rapid growth in money supply, an explicit inflationary exchange rate policy, and a collapse in confidence (and/or utility) for the Zimbabwe dollar.
Though inflation is not new over there and general confidence in the currency is already quite low, a government supported disruption in the farming process in Zimbabwe has led to an accelerated lack of confidence in the (economy) currency by those who typically sell goods and services for it. For, a currency is only as good (hard) as the economy, government, or assets that support it. And the more (quantity) of unsupported currency that there is in circulation, the more of it will be required to buy the basic necessities of life, at some point.
Thus, prices in this "soft" currency will rise. There is no sudden shortage of these things available in Zimbabwe, nor is there a sudden acceleration in demand (remember, the unemployment rate is 50%), yet their inflation rates have been soaring. This is what a loss in the purchasing power of a currency looks like. In fact, you might say that should confidence in a particular economy or government decline, the currency in circulation should become less hard. And, I will say it again; it should not be called stagflation! That is misleading.
But does not the military disruption cause a shortage in goods and services and hence, a supply shock? In what; tobacco? Sure, but before you get too excited, consider which comes first, the inflation or the supply shock that typically fuels the fire:
"Retailers this week suffered losses of over $25 million after riots broke out in the capital in protest at hikes in the price of bread and other commodities." Zimbabwe Independent, 20 October 2000.
As a result, the retailers shut down and indeed, effectively forced a supply shock. But only after the galloping inflation forced a confrontation with rioting customers. So the answer to the question:
How can shortages of hard currency result in inflation rather than deflation?
The answer is because you need a currency to buy things with, which means that the people who sell you the goods and services, will have to have confidence in your economy, your government, or investment environment. In this case, the production of tobacco is their main industry and thus, that which supports the value of the Zimbabwe dollar.
So, can it happen here?
Plainly, there is still high relative confidence in the US dollar, compared to many of the other global currencies. You can see that simply by looking at the chart below. But perhaps it is timely to discuss this confidence. Doug Noland4 hit the nail right on the head, with his brilliant insight into liquidity:
Liquidity seeks out inflation, while avoiding deflation like the plague.
What does that have to do with confidence in the dollar though? Thinking about it in this way, global liquidity continues to seek out the dollar because… for the same reason that foreign interests really have confidence in the dollar… due to its ability to inflate global purchasing power. Right, now we're on the right track. Before you write that off as misplaced cynicism, consider which is the industry that primarily supports the dollar's role as a preferred medium of exchange today. I will spare you the charts and data, but suffice it to say that it is US dominance in global finance. The American financial services industry (banking, brokerage, insurance, etc.) is the largest in the world as well as the largest domestic industry in the country, especially if you include the 50,000 day traders that used to account for more than a quarter of the trading volume of our major exchanges on any given day. The Federal Reserve System has become the global lender of last resort, implicitly.
It is no coincidence, therefore, that the oil bull is gaining ground as confidence in the US investment environment has begun to ebb. Remember that for much of the nineties, the "inflation" environment appeared relatively benign. We had some economic growth up until the mid nineties, but then it became less clear whether we had any real growth or whether we were in the midst a monetary delusion. Perhaps because Mr. Greenspan chose to become an optimist (a character trait that would have been blasphemous in old economy banking circles), many economists will argue that productivity, technology, and low inflation in dollar terms underlie the dollar's incredible strength. And they might argue that Europe and Japan are even worse off anyway, which is why they always have currency woes.
Now, I have talked a lot about this5, so I do not think I need to say anything more intelligent about it here, except that it is plain Poppycock (nonsense). These things do not determine exchange rates, only confidence and flows do. To the extent that these things affect confidence and capital flows, however, they certainly are important. Having said that, they are equally likely to affect confidence, as confidence is likely to affect them. That means exactly what I say… that it is the dollar's strength, which has ballooned the recent productivity data, created the financially conducive inflationary environment, the availability of capital for technological innovation, as well as the foundation for soaring equity prices. In fact, someone debating these economists might even bring up the possibility that the dollar system, which has been so beneficially strong for the US economy, has created this wonderful superficial environment at the expense of other global currencies / economies.
As American power brokers continue to broker one carry trade after another, foreigners accept dollars from US consumers because so far, they have paid their debts to them. Foreigners allow their investments to stay in dollars because they have been persuaded that the long-term capacity of the US economy to expand has undergone a vast structurally bullish adjustment. Such that it outweighs the consequences of a structurally mature US consumer, mortgage, corporate, government, investment, and dollar based credit cycle. Many people have also been persuaded that the dollar can withstand inflationary pressures, and as a result, is wrongfully perceived as a sound long-term store of value.
Have another look at the two charts above (dollar and oil), and note the rise in oil prices EVEN as the exchange rate of the dollar rises against other currencies. This kind of move in oil has not happened since the Gulf war. It is my argument that the rise in commodity prices is less a supply and demand issue than a monetary one. Plenty of dollars have been created this decade, and if our hypothesis is correct, they should begin to manifest in higher and higher prices for real things as the international community begins to lose confidence in the US economy and the stability of its financial markets.
Furthermore, what if they (the Greenspan Fed) are also wrong about productivity? Not so much conceptually, as there is not a doubt in my mind that advances in science and technology always contribute, but as regards their ability to honestly measure it today. Though even conceptually, it is difficult to be objectively persuaded that the technology the US economy has created has provided the same impetus to corporate profitability as did the remarkable discoveries in the twenties; The assembly line invented by Henry Ford just before the twenties may have created the entire middle class of America, the ability for the Utility companies to offer electricity to all of American industry accelerated into the twenties, the railroad system evolved into a massive "highway," which was a huge advance and benefit to industrial and market development.
For one thing, these things were all invented years earlier, before the go-go twenties had arrived. Thus, recent productivity gains (if there indeed are any) may be reflecting nothing more than the accelerating, long awaited benefits of the mass distribution of the Personal Computer, rather than the immediate benefits of the Internet to the US economy. Those we do not understand yet, regardless of how many times Mr. Greenspan uses the word remarkable. And perhaps the reason that we haven't quite figured them out is that Wall Street thinks it has.
Greenspan holds his ground
I enjoy reading Mr. Greenspan's speeches. I think he is the most deliberate speaker I have ever had the pleasure to read. "However imprecise," he gives us great insight into the reality of Fed Policy today. Choosing the right monetary policy is incredibly difficult, I will concede. But as far as historical structures are concerned, perhaps he should refer us to the fact that past structures have by far always proven to be far more reliable than human forecasts of the future. At least they are anchored in something. The theoretical structure and natural economic laws of money and credit will never change, only the way that you look at them will. For we did not invent these laws, we only observed them as "Law."
Let us not delude ourselves into accepting as confirmation economic information, which is inherently a product of money / credit growth! And you can take that to the bank (pun intended). You will not be able to determine the difference between real growth and illusory growth until all of the other prices follow energy prices higher. And by then, Mr. Greenspan's supporters better hope that he is correct about his capital deepening contention.
As usual, much ambiguity blurs any comprehension of his personal views, but I take particular exception with his apparent failure to recognize inflation for what it really is. An "equity" bubble is one thing, but the man is a banker and the guardian of our international reserve currency.
On 05 September 1997, in a speech at Stanford University, Mr. Greenspan told us two things. First, that monetary policy continued to move further away from any sort of automaticity whatsoever and more toward discretionary rule, by the FOMC. This was due to the fact that traditional definitions of money made interest rates too sensitive to promote growth in an economy where many broader definitions of money were being accepted as an adequate medium of exchange. Second, he defined inflation for us, but reasoned that perhaps the best way to treat the monetary aggregates is… "Out of sight, out of mind."
"Increasingly since 1982 we have been setting the funds rate directly in response to a wide variety of factors and forecasts. We recognize that, in fixing the short-term rate, we lose much of the information on the balance of money supply and demand that changing market rates afford, but for the moment we see no alternative. In the current state of our knowledge, money demand has become too difficult to predict."
"Nonetheless, we recognize that inflation is fundamentally a monetary phenomenon, and ultimately determined by the growth of the stock of money, not by nominal or real interest rates. In current circumstances, however, determining which financial data should be aggregated to provide an appropriate empirical proxy for the money stock that tracks income and spending represents a severe challenge for monetary analysts."
That was three years ago. Today he looks like a genius to anyone that believes he has solved the inflation riddle by allowing the private sector room to create whatever currencies it deems convenient, and thereby the greatest ephemeral economic expansion in history.
Last week, he confirmed his position on how "antiquated" models based on any sort of monetary anchor are still irrelevant as we are still in the middle of a big technological shock and thus we still do not know which aggregates are most appropriate to define.
"To be sure, inflation is at root a monetary phenomenon. Indeed, it is, by definition, a fall in the value of money relative to the value of goods and services. But as technology continues to revolutionize our financial system, the identification of particular claims as money, near money, or a store of future value has become exceedingly difficult. Although it is surely correct to conclude that an excess of money relative to output is the fundamental source of inflation, what specifically constitutes money is a notion that has, so far, eluded our analysis. We cope with this uncertainty by ensuring that money growth, by any reasonable definition, does not reach outside the limits of perceived prudence. But we have difficulty defining those limits with precision, and within any such limits, there remains significant scope for discretion in setting policy. "
He also proved that he knows what inflation is… an excess of money relative to output, which ultimately manifests in a fall in the value of money relative to the value of goods and services (output). Thank goodness for that. Yet he has the gall to suggest that in his estimation money growth has not exceeded the limits of perceived prudence? There is plenty of "soft" money issued by the private sector banking system and financial intermediaries today. Credit market analysts have been pointing this out to us for years, but it is now showing conspicuous signs of this softness when we try to exchange it for basic necessities such as oil.
Though it took him about eight paragraphs to do so, Mr. Greenspan suggested that implicit in the fact that volatility in the six year crude oil future/forward contract has been relatively more stable, and which obviously reflects the remarkable new exploration technologies and their effect on the cost of marginal production, that the current spike (if indeed that is what it is) is temporary. Furthermore, he reasons that it is the result of OPEC production cuts (3 million barrels a day), which were withdrawn from the global oil market in 1999, which caused the "dollar" price of oil to soar from $10 to $35 in 21 months.
What he forgot to mention is that the world consumes roughly 80 million barrels of crude each and every day. He also forgot to mention how much successful exploration would have to be done over the next three to five years, to bring prices closer to the price of the irrelevant 6-year futures contract. And while there certainly were fundamental imbalances building in the crude market, there currently are equal imbalances in other commodity markets, which he conveniently overlooked to mention. It is true that to some extent, the industry possibly assumed too much confidence in "just in time inventory models" for crude at the time, but it is difficult for me to accept that 3 million barrels per day would account for the forces, which forced prices up over 200% in less than two years. And that, against a currency that has gained 20% on average, against its major trading partners. Furthermore, he says that:
"The remarkable surge in shipments of home heating oil, both here and in Europe, suggests very heavy precautionary oil accumulation by dealers and households not covered in the usual data on inventories for the industry. "
Yet, in the next paragraph, he conveniently chooses to conclude that this "hoarding" will turn into a deluge of available oil inventory on the market. He doesn't use the word hoarding, of course, I do. He uses the word, "accumulation." Big difference. It is scary that the banker in charge of managing the reserve currency "claims" that he does not recognize a natural symptom (human action) of inflation when he sees it. It is even scarier that he goes to great lengths (about 13 paragraphs) to focus your attention to the supply side of the oil market. Not that demand (2 paragraphs) should matter a whole hell of a lot to him either, but it is no longer puzzling to me that he does not want to explain the oil price spike as a loss of purchasing power (zero paragraphs) in the dollar. That should puzzle no one. Perhaps someone ought to remind him of the following wise words:
"A central bank, while needing to be open to evidence of structural economic change, also needs to be cautious. Supplying excess liquidity to support growth that turns out to have been ephemeral would undermine the very good economic performance we have enjoyed. We raised the federal funds rate in March to help protect against this latter possibility, and with labor resources currently stretched tight, we need to remain on alert." "Whatever its successes, the current monetary policy regime is far from ideal. Each episode has had to be treated as unique or nearly so. It may have been the best we could do at the moment. But we continuously examine alternatives that might better anchor policy, so that it becomes less subject to the abilities of the Federal Open Market Committee to analyze developments and make predictions."
"However, so long as individuals make contractual arrangements for future payments valued in dollars and other currencies, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output, and hence of price, that is recognizable to producers and consumers and upon which they will base their decisions."Both quotes are from his speech in 1997.
Under the current monetary system of fractional reserves and discretionary monetary policy, two variables will always combine to make up a price: the influence of the interaction between supply and demand, and the loss or gain in the purchasing power (which is invisible to the calculator) of the currency in which the good or service is priced.
As long as there is no anchor for monetary policy and as long as policy makers choose not to recognize the forces of inflation when they see them, I will argue that the error will occur on the inflation side of the price stability question. And the longer that it takes for policy makers to accept responsibility for their delusional gamble on productivity, the harder it will be for them to do so when all prices begin to accelerate.
1. From the title of Alan Greenspan's speech in the late 1960's on Gold and Economic Freedom, where he proved that there is no economic freedom without an honest monetary system, free from the political biases that have destroyed otherwise sound currencies throughout history.
2. A high reading is perceived as revealing a contrarian buy signal, while a low reading might expose a sell signal.
3. An average price for the dollar weighted against its major trading partners.
4. Mr. Noland writes the credit-bubble bulletin for PrudentBear. His summaries may also be found at our website; SafeHaven.
5. If you have not read my report before, you may find all of my past work archived at SafeHaven.